In capital markets terms, there is only one major player in Germany. Deutsche Bank’s position of dominance looks set to be confirmed by the takeover of Dresdner Bank by Commerzbank: it will create a large domestic retail and corporate banking competitor, but one that will pull back from riskier investment banking businesses. Mark Baker reports.

Deutsche Bank is the German capital markets leviathan. Its dominant position in the country looks set to increase now that Commerzbank is expected to close down much of the investment banking activities of Dresdner Kleinwort following its acquisition of Dresdner Bank from Allianz.

Deutsche has also weathered the credit crunch storm better than many of its global peers. Based on a bearish call on US housing issued by one of its analysts ahead of the rest of the Street, the bank positioned itself well for the early stages of the crisis.

But it was subsequently caught out, ending up overloaded with positions in super senior tranches, contributing to a €1.56bn loss in fixed income trading in the third quarter of last year.

It recovered that position somewhat in the fourth quarter of last year, however, and notably recorded no writedowns for the quarter. That meant that the bank managed to record a 5% increase in annual pre-tax profits, to €8.7bn, although profits fell 22% to €4.2bn in corporate banking and securities – the division that contains the corporate and investment bank’s trading and origination activities.

Conditions again worsened after that, with more writedowns on Deutsche’s leveraged loan positions helping to take it to its first quarterly loss at group level for five years in the first quarter of 2008.

Its corporate banking and securities division lost €1.6bn in that quarter, after writedowns of €2.7bn, taking the entire bank to a pre-tax loss of €254m. CEO Josef Ackermann described conditions as “the most difficult in recent memory”, and said that the quarter had seen the most intense pressure on the banking industry since the credit downturn had begun.

That worsening assessment has had a sharp impact on the bank’s share price, which had until this year held up reasonably well through the second half of last year (see accompanying chart). The stock is now trading at levels last seen in late 2004.

The second quarter of this year saw the bank record a loss of €311m in its corporate banking and securities division after writedowns of €2.3bn, although at a group level the firm reverted to profitability. And client flows and trading performance – especially in FX, money markets and rate products – have started improving again, as well as results in prime broking.

Ackermann has remained bullish on the firm’s prospects, based on its ability to record a profit over the course of the first year of the crisis. “A year has now passed since the beginning of the credit downturn, and over this period, Deutsche Bank has earned a total of €3.1bn in net income,” he said in his Q2 2008 message to shareholders. “We have shown our strength in difficult conditions.”

Formidable in bonds

The bank has remained a formidable force in the euro bond markets. As of late August this year, the bank had retained its first-place rankings from last year in all international bonds, all bonds in euros and all Euromarket issues, according to data from Thomson Financial league tables.

Debt bankers at the firm said the message internally from the very first day of August 2007 was that the world had changed: all work was to be done on new assumptions – meaning the firm often appeared to be more bearish than rivals. In particular, deals it led for Nationwide and HBOS in September, as well as several issues in its own name, attracted criticism for pricing wider than initial guidance or for appearing to be out of line with the market.

Nevertheless, bankers involved in those transactions said they have not tightened since, and now look very rich. They argued that it was others’ perceptions of what the market would bear at the time that were out of line.

Bankers at the firm said there has been a huge focus on the debt side of the business on making sure that clients – both issuers and investors – have a proper understanding of the nature of the crisis and of what market conditions will allow.

"A high priority for us was education. Keeping on top of what the changing conditions mean for our customers' funding plans has been a significant job for us,” said Miles Millard, head of DCM Europe at Deutsche Bank. “The emphasis has switched from borrowers to investors now. Staying on top of reverse enquiry and rapidly changing investor sentiment has been critical to providing clients with a good steer.”

One example cited by Millard is a change during summer 2008 away from the shorter-dated maturities that had begun to dominate issuance and the emergence of demand for longer maturities. The bank was able to successfully capitalise on this trend during what was the busiest August for 10 years in European debt issuance.

Deutsche’s emerging market business remains strong, although this year a proportionately large boost has come from a barnstorming Latin American performance. So far this year it has secured a 21% market share in Latin American bonds, pushing it into first place, up from fifth for the whole of 2007. Its emerging Europe and Africa ranking has slipped from second to fifth.

All financial services firms have faced breathtaking challenges over the last twelve months, but for some the potential impact is greater. For example, Deutsche has been a driving force in securitisation and in high-yield bonds in the past – it was the market leader in European high-yield last year, with a 20% market share, and ranked third for all international securitisation issuers.

From a revenue perspective then, the firm stands to suffer more greatly than some peers from the virtual shutting down of these markets. At the same time, the bank boasts a more diversified offering than many competitors, and could therefore be better placed to deal with revenue reductions in some areas.

But two still-active markets where the bank’s DCM business has taken a hit are the agency and supranational sectors. As of early September, the bank did not even figure in the top 10 bookrunners of euro-denominated transactions for agencies – a far cry from its market-leading position in 2007. It has also disappeared from the top rankings for supranational issuance in euros, down from last year’s second place.

The fact that agencies have moved towards more dollar issuance this year has certainly not helped Deutsche’s cause, but it does not explain the bank’s absence from the rankings.

Debt capital markets officials at Deutsche said the agency business is a tap that can be turned on and off relatively easily, and that it is also an area fairly susceptible to pure league table-generating business. Nevertheless, they also hinted the bank may be active in this business before the end of the year.

Losing ground in ECM

There are weaknesses elsewhere too. The bank’s ECM business has for a long time been among the top European franchises, but this year its ranking has slipped to a disappointing eighth place.

That performance contributed to a big fall in Deutsche’s global equity origination revenues in the first half of the year. The bank recorded €224m in revenues for the period, compared with €446m in the first half of 2007 and €861m for the entire year.

That 50% drop in revenues for the first half is hardly explained by an equivalent drop in market activity. At the end of the first half, European ECM volumes had fallen by just 5% compared to the same period in the previous year – a remarkable fact considering the volatility of the markets – but Deutsche Bank’s bookrunning credit had collapsed by more than 70%.

The result pushed the bank to the very bottom of the top 10 rankings for the first half of this year, compared to a comfortable first place at the end of the first half last year. As of early September this year, the bank was languishing in eighth place.

According to those at the firm, the fact that so much of the European business has been made up of giant capital increases in the UK has worked against it. The lumpiness of the business in the first half is easily shown by the 30% drop in number of deals.

The flipside of this is that the bank has actually been disadvantaged by its strong corporate relationships in Germany: the economy looks set to weather a broader downturn better than some other European markets, and there has not been the demand for rescue equity financings from distressed companies that might have benefited Deutsche’s ECM franchise.

Elsewhere, the bank has been conflicted out of the two big equity trades that were behind M&A financings in the first half, namely the Carlsberg bid for Scottish & Newcastle (for which Deutsche was on the defence side), and the financing for Imperial Tobacco’s acquisition of Altadis (Deutsche is close to the Spanish company).

Despite the difficulties, the bank has still found some success. With 17 completed equity issues as of the end of August, Deutsche is in the top five by that measure. Bankers there also proudly point to only one deal pulled this year, putting it ahead of some rivals.

It has also brought to market the first European special purpose acquisition company (SPAC), the Germany 1 vehicle. The €250m sale was well received by the market, although its success also depended on a big effort to sell into Deutsche’s private banking clients: the bank took almost 10% of the deal.

Nevertheless, banks must respond to changing market environments or suffer the consequences. If it cannot easily muscle its way into where equity activity is set to be, and if the broader IPO markets stay depressed, then Deutsche will inevitably have to look to revise its cost base in this business.

The bank has been a regular reorganiser of its structures, and the last twelve months has been no exception. In making its staffing decisions on the equity side, for example, it has boosted its emerging markets capabilities and also toned down its focus on block trade business, when it became obvious that a predicted glut of overnight trades was not going to materialise in the current market conditions.

In addition, at the start of September Deutsche created the role of European head of financial institutional capital origination, in response to the specific challenges faced by financial institutions. The role, taken by Tiina Lee, straddles ECM and DCM and will aim to secure Deutsche a bigger slice of the pie in what is expected to remain a very busy sector.

One less competitor

As far as capital markets and investment banking activity goes, Deutsche received a big competitive fillip at the end of August, with the announcement of a long-awaited deal for Commerzbank to buy Dresdner Bank from insurer Allianz.

The transaction, in which Commerzbank will take an initial 60% stake in Dresdner Bank in January 2009, values Dresdner at €9.8bn. That value is offset by a €975m risk shield that has been put in place to absorb new ABS-related losses. Allianz will only receive money out of the risk shield that is left after any losses.

The future shape of the merged firm will only become clear in early 2009, and the deal is currently a work in progress. But Commerzbank has for some time been scaling back its investment banking and capital markets activities, particularly in more risky areas.

Nick Teller, who left the bank earlier this year, had taken over the corporates and markets division at Commerzbank in late 2004. The division, which takes in the firm’s capital markets and investment banking activities, had dropped into a loss on the back of a poor performance in proprietary trading.

Teller presided over a turnaround in fortunes, pushing the business hard in areas such as equity derivatives and covered bonds (it acquired Eurohypo in 2006, making it the largest issuer of covered bonds in Europe).

However, in 2006 the New York branch of the bank was brought into the corporates and markets umbrella. An ill-advised bet by a small team of structured investment traders there brought a €395m sub-prime CDO write-down in 2007, almost offsetting the entire corporates and markets global profit for the year. It left the division with a profit of just €23m.

That situation could have been a lot worse: at one stage Teller is thought to have been asked to approve further sub-prime investments worth billions, but rejected them.

In the first half of 2008 performance improved, with fixed income trading swinging back into positive territory in the second quarter, helping to reverse a first quarter loss of €50m for the division to a €82m profit for the first half.

The strategy of Michael Reuther, the new head of the corporates and markets division, has been focused on the bank’s successful areas such as equity derivatives. The bank does not seek to be a player on jumbo capital markets deals, and is increasingly less likely to be risking balance sheet to gain market share.

It is, however, present in areas such as leveraged finance, although with the emphasis very much on lower leverage multiple business and work with mid cap corporates, an area that has not experienced the disasters seen in larger transactions. Its €3.1bn LBO portfolio – with an average position size of €30m – did not incur any write-downs in the first half of 2008, for example.

Dresdner Kleinwort has been a much more significant investment banking and capital markets player, but does not look set to be in the future. Although at the time of writing Commerzbank had not detailed the shape of the new business, it looks certain that after the first stage some of the more far-flung parts of DK’s franchise will be shut down – Tokyo, for example, and some of the US operation.

In addition, its London-based equities trading franchise and M&A advisory operation (and the non-German ECM work that is also based there) is likely to be drastically reduced or cut altogether. Lending is also likely to be scaled back, both in the leveraged space and also in the emerging markets where DK has been spreading its wings.